This article was posted on Tuesday, Jul 01, 2014

As Baby Boomers age, they realize that things may need to change with how they handle their real estate investments. First of all, they may be tired of dealing with the details that are involved with the day to day operations of real estate investments; secondly, they start having to come to grips with their mortality and may not want their spouse or family to have to deal with those investments. Finally they may be concerned about the tax implications involved with selling their assets; inasmuch as the direct sale of a property could cost forty percent or more of the capital return.

Making decisions regarding the future of existing real estate investments is much like selling a business. Typically, most real estate investors spend a lifetime [40–50] years building a retirement vehicle, poured blood, sweat and tears into their investments to build a legacy. They are now faced with decisions on how to maintain a sufficient cash flow during their lifetime and transitioning their assets either to their spouse, children, grandchildren or charitable organizations.

There are many different directions baby boomers can choose to reposition their real estate investments to prepare for retirement and / or to reduce the time and energy needed to manage them. These include:

  • Selling their real estate investments
  • Family succession planning
  • Selling to partners
  • Contributing to a charitable organization
  • Repositioning your portfolio
  • Using a 1031 exchange to invest in an UPREIT

(Umbrella Partnership Real Estate Investment Trust)

  • Tenant in Common Investments
  • Hiring a property manager

Sale of the Real Estate Investments

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Typically when investors choose to sell their real estate holdings, they are faced with the following costs, taxes and possible prepayment penalties:

  1. Federal Taxes – Federal capital gains: 20% Federal Medicare tax: 3.8%
  2. State Capital Gains (depends on state) – 13.3% (California) (Note: Capital Gains tax rates vary depending on whether the gains are short-term or long-term.) RED FLAG: Depending on the number of 1031 exchanges involved with their holdings, the state’s revenue departments (tax collectors) will come after the investor to recapture taxes one may have put off paying in the past closings. Should you die before the state gets its share, the beneficiaries basis in the properties received from the decedents estate is valued at the properties Fair Market Value at date of death or six months later. (The estate has an option regarding the valuation date.)
  3. Real Estate Transfer Taxes (state and county) Go to this chart to decode the transfer taxes in California. http://
  4. Local City and County Business Taxes
  5. Federal Depreciation Recapture, which is 25% of the depreciation written down over the life of the ownership of the property. RED FLAG: This could be a huge number depending on the number of 1031 exchanges one has closed to get to the final exit sale since with each 1031 the property basis is typically adjusted, though you can avoid those taxes at death. Upon death, property basis is “stepped up” to Fair Market Value at date of death or six months later.
  6.  Prepayment Penalties – Many properties have underlying financing issues the most important being the prepayment penalty. With Commercial Mortgage Backed Securities (CMBS) loans, an investor may have yield maintenance clauses and with other loans there may be percentage payoff between one and five percent of the outstanding loan balance, which might last over ten years. These penalties are a significant issue and need to be calculated into the costs of sale as one makes the critical decisions to sell and exit the real estate investment marketplace. 

These significant expense hits (Tax and prepayment penalties) frequently make real estate investors uneasy, so they tend to look at other ways to exit or reposition their real estate holdings.

Family Succession

Many investors dream of leaving their hard built real estate “nest egg” to their families. Unfortunately there are many challenges with this plan. Most important is that one will need to find a family member who is mature enough, has an interest and wants to learn about the family’s existing real estate investments. This typically proves very difficult to do.

Real estate investors tend to forget that they made many mistakes building their portfolios. They expect the next generation to make the “right” decisions, just like they did. This is an unrealistic expectation. The next generation needs to be mentored and educated; patiently, over time. Decisions need to be discussed.

An investor might request their successor(s) to take real estate and/or finance classes to prepare them for their future decision making. They should be involved in the basics: Property inspections, financial reviews, attorney meetings, refinancing and purchasing decisions. Finally they should draft long and short term plans on paper to insure a record of their plans.

Use this process as a road map for family leadership. Remember that over time one needs to relinquish control, if the transition is going to be successful. This does not mean relinquishing control of your income, just planning and decision making. Yes, mistakes will be made.

Consider relinquishing control a small step at a time so that your successor(s) can learn in a controlled environment. At the same time, if there are numerous “stakeholders”, children, grandchildren, nieces and nephews, create a reporting relationship that is reasonable. Decide who is going to make the decisions. Create dispute resolution processes. Don’t let disagreements in the family ruin your investments.

Have a plan B in place in case your next generation manager gets ill and can no longer serve in his or her role.

Most important is that you, as the owner of the investments, understand the next generation’s needs. In every generation there is most likely one of the following:

  • A thrifty spender
  • A very conservative investor
  • A very risk oriented investor
  • A very sophisticated investor
  • Someone that does not get along with the others
  • Someone who needs cash to pay for the kids college
  • Someone who needs cash to retire or make their house payment
  • A child with a disability or a mental illness (a conservator needs to be appointed to protect their interest)
  • Someone that has no interest in real estate at all and is willing to opt out of all decision making
  • A son or daughter in law that have different ideas from the rest of the family.

One needs to plan ahead with your estate and real estate attorney to build a Trust structure that addresses the needs of the next generation. Remember also that at some point in time (with the exception of those of you that have property inAlaska) that these real estate trusts that you build, will not last into perpetuity.

Note: Whichever option you choose, have a designated person to manage your real estate in case you are hit by a car or suddenly become incapacitated.

Sale to Partners

This is the easiest one to accomplish, if you planned ahead. In other words you added a buy sell agreement into your other partnership agreements. Of course this is dependent on how your partnership was formed. If one has planned this in advance, you most likely crafted a partnership agreement or more likely formed an LLC. In that agreement you addressed the terms of your partnership.

If on the other hand you had been operating on love and trust alone, now is the time to draft those agreements and spell out everything, including how to value the real estate assets once you exit. You will want to sit down with your CPA and attorney to review the tax implications of this decision and plan out if it is possible to defer or avoid some of the income taxes on the sale of your shares of the property.

Note: Minority partner discount (fractional interest): Sales or partnership interests are generally valued at Fair Market Value (FMV). The FMV of a third party arms-length transaction may include a discount for owning a non-controlling minority interest. That is a matter between the buyer and seller. The IRS has accepted up to 30% value discounts in the valuation of fractional interests. Transfers to trusts for estate planning purposes may also be valued at a lesser amount – minority discount. The issue here is reduction of the gift/estate tax upon demise of the property owner.

Contribute to Charitable Organization

You can always donate all or part of your properties to a charity via a charitable remainder trust (CRT). The advantage to doing this is that the size of the tax deduction is based on the then current market value of the property, not its cost basis.

If structured properly, the CRT can pay you an annuity (income for the balance of your life, or for a specified term, and then distributes what is left over to the charity.) As a tax exempt entity, the CRT can sell the real estate donated tax free and reinvest the proceeds in income producing assets (that are typically more liquid than real estate). You do have to pay income taxes on the distributions you receive, but each payment may include a combination of ordinary income, capital gain and tax free return of principal. The charity can also buy an annuity in your name from the proceeds of the sale of the real estate investment.

Critical tax potholes you need to sidestep:

  • Substantiate the value with an appraisal as part of the donation process. Don’t just estimate a value; the IRS might disallow the donation. For properties over $500,000 you must attach an appraisal to your tax return.
  • If the charity sells the property within three years of the donation ( most do in the first year), and the property sells for less than the appraised value, the IRS will most likely challenge your deduction.
  • Donating properties that are free and clear is a cleaner process than donating one with a mortgage still in place. According to Attorney Peter Lennington of the Lennington Law firm PLLC,St PaulMinnesota, you might end up recognizing taxable income for some of the outstanding mortgage’s value.
  • Don’t prearrange the sale of the property before it is donated to the charity. If you do the IRS will disallow the donation and you will have to pay capital gains taxes.

Giving real estate to a charity is not easy. Many charities are not geared to accepting real estate; they want cash or stocks etc. If they take real estate they have to figure out how to manage it and sell it, not always an easy task. Most charities prefer donations without a mortgage because of the complicated tax implications. It is not unusual to have a home donated to charity with a life estate attached also known as a “Gift of a Remainder interest with a Life Estate”. This donation process takes time and has to be planned in advance. For more info see this link:  http://  should-i-donate-my-house-charity part-4-donating-your-house-and reserving-life-estate.

Repositioning Your Real Estate Portfolio

One way to simplify your real estate portfolio is to reposition your assets. Assuming you have a multifamily portfolio, you might want to transition out of those assets and trade into quality triple net (NNN) investments, with longer term leases. There are tradeoffs in making this decision, primarily as the market changes you can typically adjust your rents with multifamily tenancies.

Commercial long-term leases don’t have the same flexibility and the rents with national AAA tenant leased properties, which typically only increase 10% over a five year period with adjustments coming at the lease anniversary mark. On the other hand they are triple net leases and the tenants are picking up almost all of the costs in taking care of their buildings. Though it bears remembering that critical to a successful investment in a NNN property are a great location and a financially strong tenant. This may mean that you trade a higher yield for a lower yield but the benefit is a long term tenant and an easy monthly check with no midnight calls for maintenance.  Note: Single tenant investments exist with medical, retail, industrial and office tenancies. It pays to do some research before you decide on a tenant and an industry group.

Use of 1031 Exchange to Invest in an UPREIT (Umbrella Partnership Real Estate Investment Trust)

Basically, to take advantage of an UPREIT, you sell your property on the open market using a 1031 exchange and then using your 1031 proceeds you invest in a REIT. Then, by virtue of a 721 exchange, the assets are traded into shares of the REIT. It is possible to just trade your investment into a REIT, but that rarely happens because UPREITs want to be able to choose their own property focus. It looks like this:

The first step is selling the relinquished property and structuring a 1031 Exchange. However, instead of searching for suitable replacement property, the investor identifies and acquires a fractional interest (tenant-in-common interest) in real estate that the REIT has already designated. This completes the 1031 Exchange portion of the transaction.

The second step is to contribute the fractional interest into the operating partnership after a holding period of 12 to 24 months as part of a 721 Exchange (tax deferred contribution into a partnership). The investor receives an interest in the operating partnership (OP) in exchange for his or her contribution of the real estate and is now effectively part of the REIT.

Bottom line is that you need to carefully investigate all of your investment strategies. You should hire advisors you trust. Hire experienced CPA’s, attorneys, and real estate advisors. 

Benefits of an UPREIT

The benefits of an UPREIT are numerous, most importantly they deliver a tax deferral strategy to the holder of the real estate. In trade for your property, you receive a return on your investment and someone else is managing it for you. The real estate investor just has to cash the quarterly check and does not have to pay capital gains on the sale of the real estate asset.  To summarize an UPREIT:

  • Provides a viable tax deferral/ avoidance exit strategy to property owners facing significant capital gain tax liabilities on the sale of appreciated property with a low tax basis.
  • Allows diversification of real estate holdings (i.e., OP Unit Holders have an interest in a portfolio of properties instead of just one).
  • Gives one potential to convert liquid‚ long-term assets (i.e.‚ real estate) into more saleable securities (i.e., OP Units → REIT Share → Cash).
  • Eliminates or reduces property management responsibilities or concerns.
  • Provides quarterly income distributions.
  • Provides potential to recognize unrealized gains as earnings.
  • Can provide professional management and expertise in capital markets.
  • Avoids risk of negative cash flow.
  • Establishes estate simplification.
  • Allows the owner to dispose of property in a way that maximizes its value.
  • Can improve cash position through potential leveraging of OP Units.

UPREITs can help you restructure your real estate assets and make it easier to give away or inherit after your death. If structured correctly, ownership in UPREITS might not result in a taxable event until the shares are sold; however when doing business with another company you must carefully vet the strength of the company, its history and its future goals, as well as the experience of the officers running the REIT. Additionally, remember they are trying to make a buck as well. It is very important to understand all of the costs that are involved with in-vesting with an UPREIT and the ups and downs of the stock market as well.

Note: Fore more details regarding the definition of an UPREIT, see from the Exeter 1031 website.

TIC Investments

Tenant in common investments were a common real estate investment vehicle before the market downturn in 2008. Then the short term mortgages that many of them were financed with needed to be refinanced and financial institutions were loath to refinance, because vacancy rates had increased and income had declined. Many investors lost significant assets due to the so called “TIC Meltdown”. All was not as advertised and the SEC decided that these were securities and needed to be sold by stock brokers with securities licenses vs. real estate agents.

On the other hand, out of this challenge a few companies inUtah, Rockwell and Realty Net Advisors, decided that they could mitigate investment risk by taking investors 1031 returns and place then into NNN investments where no loan was needed. In other words 100 % of the purchase price for a single tenant investment came from 1031 proceeds that investors placed in the pool. They also focused on very small investments in the $1,000,000 range, possibly to avoid securities regulations.

This means less risk for the investors, because the worst thing that could happen to the investors is the loss of the tenant, resulting in an empty building they have to re-tenant. They cannot lose the building to a financial institution since there is no loan in place. In addition, the TIC sponsors mitigate this risk, by only choosing high quality national tenants. They keep it simple. They collect the rent, charge a management fee, inspect the property and then send a check to the investor. {Note:  There is no loan in this scenario so no mortgage to pay off, this helps with upside on the yield for the property.). Average returns are in the conservative but steady 5-7% range. This also means though that you don’t have help from Uncle Sam in this kind of transaction i.e. an interest expense write off. Additionally, in this kind of a transaction don’t get the benefit of leverage which could increase your returns.

The downside is that you are in a type of a partnership and when you want to exit from this structure, you have to live by the TIC agreement. Basically in this structure, much like the UPREIT structure, you have ceded control of the investment to a third party. If the third party mismanages your property(s) you may lose all of the return from your investment. Note: Don’t forget that when you complete a 1031 exchange you also have to replace the debt, if any, you have in place in the replacement property. For more details follow these links:

Hire a Property/Asset Manager

Many investors hate spending money to have their properties managed, but a good property manager is worth his/her weight in gold. Life is simplified. You can travel, work and enjoy your family and not have to pay daily attention to your property, though you still need to be involved with your property. In pre-paring for retirement, you can have a property manager manage your as-sets for you and for the next generation as well.

Annual or semiannual property inspections, reviewing financial reports and involvement in capital expense decisions are still on your required list of things to do. These are things that your spouse/life companion can also do, should you be unable to due to an illness or other incapacity.

If you have significant assets, you might hire an experienced real estate professional in the form of an asset manager who makes all of your decisions for you, from acquisition to disposition, from long range planning to holding property managers accountable. They typically are paid a fee for services. In some cases banks have trust departments that also can manage properties for you either with their own staff or through the use of property managers; they would perform this in an asset management role, much as they manage stocks and bonds for their clients.


So how do you best protect yourself when you are ready to retire from active real estate investing? Which one of the exit strategies do you use?  In the end, your own personal situation and personal preferences will dictate or influence your decisions.

I always fall back on the thoughts of George S. Clason and his book published in 1926, The Richest Man in Babylon.* Some of his key points were as follows: “Gold clingeth to the protection of the cautious owner who invests it under the advice of men wise in its handling. Gold slippeth away from the man who invests it in businesses or purposes with which he is not familiar or which are not approved by those skilled in its keep. Gold flees the man who would force it to impossible earnings or who followeth the alluring advice of tricksters and schemers or who trusts it to his own inexperience and romantic desires in investment.”

Bottom line is that you need to carefully investigate all of your investment strategies. You should hire advisors you trust. Hire experienced CPA’s, attorneys, and real estate advisors. Spend some of that hard earned money to protect the rest of the corpus. Seek out specialists in estate planning and real estate. I recommend that you do not have your employment attorney tell you what to do. The real estate attorney, who is an expert at evictions, is the wrong person. You need to talk to someone that understands all of the exit strategies. Interview and meet many people. If your gut tells you that you are over your head, trust your gut. You will find the answer that is right for you; it just may take some time! Plan ahead!

Don’t let the tail wag the dog, understand all of the tax implications (estate tax and real estate capital gains taxes) first before you make a final decision.

*The Richest Man in Babylon – The Success Secrets of the Ancients, by George S. Clason. Publisher – Signet / First published in 1926.  

Clifford A. Hockley is President of Bluestone & Hockley Real Estate Services, greater Portland’s full service real estate brokerage and property management company..  He is a Certified Property Manager and has achieved his Certified Commercial Investment Member designation (CCIM).  Bluestone & Hockley Real Estate Services is an Accredited Management Organization (AMO) by the Institute of Real Estate Management (IREM).  

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